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Chapter 9

Chapter 9. The Analysis of Competitive Markets. Topics to be Discussed. Evaluating the Gains and Losses from Government Policies--Consumer and Producer Surplus The Efficiency of a Competitive Market Minimum Prices. Topics to be Discussed. Price Supports and Production Quotas

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Chapter 9

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  1. Chapter 9 The Analysis of Competitive Markets

  2. Topics to be Discussed • Evaluating the Gains and Losses from Government Policies--Consumer and Producer Surplus • The Efficiency of a Competitive Market • Minimum Prices Chapter 9

  3. Topics to be Discussed • Price Supports and Production Quotas • Import Quotas and Tariffs • The Impact of a Tax or Subsidy Chapter 9

  4. Evaluating the Gains and Losses fromGovernment Policies--Consumer and Producer Surplus • Review • Consumer surplus is the total benefit or value that consumers receive beyond what they pay for the good. • Producer surplus is the total benefit or revenue that producers receive beyond what it cost to produce a good. Chapter 9

  5. 10 Consumer Surplus S 7 Between 0 and Q0 consumers A and B receive a net gain from buying the product-- consumer surplus 5 Producer Surplus Between 0 and Q0 producers receive a net gain from selling each product-- producer surplus. D Q0 Consumer A Consumer B Consumer C Consumer and Producer Surplus Price 0 Quantity

  6. Evaluating the Gains and Losses fromGovernment Policies--Consumer and Producer Surplus • To determine the welfare effect of a governmental policy we can measure the gain or loss in consumer and producer surplus. • Welfare Effects • Gains and losses caused by government intervention in the market. Chapter 9

  7. Suppose the government imposes a price ceiling Pmax which is below the market-clearing price P0. S Deadweight Loss The gain to consumers is the difference between the rectangle A and the triangle B. B P0 C A The loss to producers is the sum of rectangle A and triangle C. Triangle B and C together measure the deadweight loss. Pmax D Q1 Q0 Q2 Change in Consumer andProducer Surplus from Price Controls Price Quantity Chapter 9

  8. Change in Consumer andProducer Surplus from Price Controls • Observations: • The total loss is equal to area B + C. • The total change in surplus = (A - B) + (-A - C) = -B - C • The deadweight loss is the inefficiency of the price controls or the loss of the producer surplus exceeds the gain from consumer surplus. Chapter 9

  9. Change in Consumer andProducer Surplus from Price Controls • Observation • Consumers can experience a net loss in consumer surplus when the demand is sufficiently inelastic Chapter 9

  10. If demand is sufficiently inelastic, triangle B can be larger than rectangle A and the consumer suffers a net loss from price controls. D B S P0 C Example Oil price controls and gasoline shortages in 1979 A Pmax Q1 Q2 Effect of Price ControlsWhen Demand Is Inelastic Price Quantity Chapter 9

  11. Price Controls and Natural Gas Shortages • 1975 Price controls created a shortage of natural gas. • What was the deadweight loss? Chapter 9

  12. Price Controls and Natural Gas Shortages Data for 1975 • Supply: QS= 14 + 2PG + 0.25PO • Quantity supplied in trillion cubic feet (Tcf) • Demand: QD = -5PG + 3.75PO • Quantity demanded (Tcf) • PG = price of natural gas in $/mcf and PO= price of oil in $/b. Chapter 9

  13. Price Controls and Natural Gas Shortages Data for 1975 • PO = $8/b • Equilibrium PG = $2/mcf andQ = 20 Tcf • Price ceiling set at $1 • This information can be seen graphically: Chapter 9

  14. D S The gain to consumers is rectangle A minus triangle B, and the loss to producers is rectangle A plus triangle C. 2.40 B 2.00 A C (Pmax)1.00 18 Price Controls and Natural Gas Shortages Price ($/mcf) Quantity (Tcf) 0 5 10 15 20 25 30 Chapter 9

  15. Price Controls and Natural Gas Shortages • Measuring the Impact of Price Controls • 1 Tcf = 1 billion mcf • If QD = 18, then P = $2.40 • [18 = -5PG + 3.75(8)] • A = (18 billion mcf) x ($1/mcf) = $18 billion • B = (1/2) x (2 b. mcf) x ($0.40/mcf) = $0.4 billion • C = (1/2) x (2 b. mcf) x ($1/mcf) = $1 billion Chapter 9

  16. Price Controls and Natural Gas Shortages • Measuring the Impact of Price Controls • 1975 • Change in consumer surplus • = A - B = 18 - 0.04 = $17.6 billion • Change in producer surplus • = -A - C = -18-1 = -$19.0 billion Chapter 9

  17. Price Controls and Natural Gas Shortages • Measuring the Impact of Price Controls • 1975 dollars, deadweight loss • = -B - C = -0.4 - 1 = -$1.4 billion • In 2000 dollars, the deadweight loss is more than $4 billion per year. Chapter 9

  18. The Efficiency ofa Competitive Market • When do competitive markets generate an inefficient allocation of resources or market failure? 1) Externalities • Costs or benefits that do not show up as part of the market price (e.g. pollution) Chapter 9

  19. The Efficiency ofa Competitive Market • When do competitive markets generate an inefficient allocation of resources or market failure? 2) Lack of Information • Imperfect information prevents consumers from making utility-maximizing decisions. Chapter 9

  20. The Efficiency ofa Competitive Market • Government intervention in these markets can increase efficiency. • Government intervention without a market failure creates inefficiency or deadweight loss. Chapter 9

  21. S When price is regulated to be no higher than P1, the deadweight loss given by triangles B and C results. B P0 C A P1 D Q1 Q0 Welfare Loss When PriceIs Held Below Market-Clearing Level Price Quantity Chapter 9

  22. When price is regulated to be no lower than P2 only Q3 will be demanded. The deadweight loss is given by triangles B and C S P2 A B P0 C What would the deadweight loss be if QS = Q2? D Q3 Q0 Q2 Welfare Loss When PriceIs Held Above Market-Clearing Level Price Quantity Chapter 9

  23. The Market for Human Kidneys • The 1984 National Organ Transplantation Act prohibits the sale of organs for transplantation. • Analyzing the Impact of the Act • Supply: QS = 8,000 + 0.2P • If P= $20,000, Q = 12,000 • Demand: QD = 16,000 - 0.2P Chapter 9

  24. The 1984 act effectively makes the price zero. S’ S B D The loss to suppliers is given by rectangle A and triangle C. If consumers received kidneys at no cost, their gain would be given by rectangle A less triangle B. $20,000 A C Rectangles A and D measure the total value of kidneys when supply is constrained. D 12,000 The Market for Kidneys, and Effectsof the 1984 Organ Transplantation Act Price $40,000 $30,000 $10,000 Quantity 0 4,000 8,000 Chapter 9

  25. The Market for Human Kidneys • The act limits the quantity supplied (donations) to 8,000. • Loss to supplier surplus: • A + C = (8,000)($20,000) + (1/2)(4,000)($20,000) = $200/m. Chapter 9

  26. The Market for Human Kidneys • Gain to recipients: • A - B = (8,000)($20,000) - (1/2)(4,000)($20,000) = $120/m. • Deadweight loss: • B + C or $200 million - $120 million = $80 million Chapter 9

  27. The Market for Human Kidneys • Other Inefficiency Cost 1) Allocation is not necessarily to those who value the kidney’s the most. 2) Price may increase to $40,000, the equilibrium price, with hospitals getting the price. Chapter 9

  28. The Market for Human Kidneys • Arguments in favor of prohibiting the sale of organs: 1) Imperfect information about donor’s health and screening Chapter 9

  29. The Market for Human Kidneys • Arguments in favor of prohibiting the sale of organs: 2) Unfair to allocate according to the ability to pay • Holding price below equilibrium will create shortages • Organs versus artificial substitutes Chapter 9

  30. Minimum Prices • Periodically government policy seeks to raise prices above market-clearing levels. • We will investigate this by looking at a price floor and the minimum wage. Chapter 9

  31. If producers produce Q2, the amount Q2 - Q3 will go unsold. S The change in producer surplus will be A - C - D. Producers may be worse off. Pmin A B P0 C D D Q3 Q0 Q2 Price Minimum Price Quantity Chapter 9

  32. Firms are not allowed to pay less than wmin. This results in unemployment. S wmin A B The deadweight loss is given by triangles B and C. w0 C Unemployment D L1 L0 L2 The Minimum Wage w L Chapter 9

  33. Airline Regulation • During 1976-1981 the airline industry in the U.S. changed dramatically. • Deregulation lead to major changes in the industry. • Some airlines merged or went out of business as new airlines entered the industry. Chapter 9

  34. Prior to deregulation price was at Pminand QD = Q1 and Qs = Q2. S Area D is the cost of unsold output. Pmin A B P0 After deregulation: Prices fell to PO. The change in consumer surplus is A + B. C D D Q1 Q3 Q0 Q2 Effect of Airline Regulationby the Civil Aeronautics Board Price Quantity Chapter 9

  35. Airline Industry Data 1975 1980 1985 1990 1995 1996 Number of carriers 33 72 86 60 86 96 Passenger load factor(%) 54 59 61 62 67 69 Passenger-mile rate (constant 1995 dollars) .218 .210 .166 .150 .129 .126 Real cost index (1995=100) 101 122 111 107 100 99 Real cost index corrected for fuel cost increases 94 98 98 100 100 98

  36. Airline Industry Data • Airline industry data show: 1) Long-run adjustment as the number of carriers increased and prices decreased 2) Higher load factors indicating more efficiency Chapter 9

  37. Airline Industry Data • Airline industry data show: 3) Falling rates 4) Real cost increased slightly (adjusted fuel cost) 5) Large welfare gain Chapter 9

  38. Price Supports andProduction Quotas • Much of agricultural policy is based on a system of price supports. • This is support price is set above the equilibrium price and the government buys the surplus. • This is often combined with incentives to reduce or restrict production Chapter 9

  39. S Qg To maintain a price Ps the government buys quantity Qg . The change in consumer surplus = -A - B, and the change in producer surplus is A + B + D Ps A B D P0 D + Qg D Q1 Q0 Q2 Price Supports Price Quantity Chapter 9

  40. Qg D + Qg Price Supports The cost to the government is the speckled rectangle Ps(Q2-Q1) Price S Ps Total welfare loss D-(Q2-Q1)ps A B D P0 Total Welfare Loss D Quantity Q1 Q0 Q2 Chapter 9

  41. Price Supports • Question: • Is there a more efficient way to increase farmer’s income by A + B + D? Chapter 9

  42. Price Supports andProduction Quotas • Production Quotas • The government can also cause the price of a good to rise by reducing supply. Chapter 9

  43. Price Supports andProduction Quotas • What is the impact of: 1) Controlling entry into the taxicab market? 2) Controlling the number of liquor licenses? Chapter 9

  44. Supply restricted to Q1 • Supply shifts to S’ @ Q1 S’ S PS A B D P0 • CS reduced by A + B • Change in PS = A - C • Deadweight loss = BC C D Q1 Q0 Supply Restrictions Price Quantity Chapter 9

  45. Ps is maintained with • and incentive • Cost to government = B + C + D S’ S PS P0 D Q1 Q0 Supply Restrictions Price A B D C Quantity Chapter 9

  46. = A - C + B + C + D = A + B + D. The change in consumer and producer surplus is the same as with price supports. = -A - B + A + B + D - B - C - D = -B - C. S’ Price S PS A B D P0 C D Q0 Quantity Supply Restrictions Chapter 9

  47. Questions: How could the government reduce the cost and still subsidize the farmer? Which is more costly: supports or acreage limitations? S’ Price S PS A B D P0 C D Q0 Quantity Supply Restrictions Chapter 9

  48. Supporting the Price of Wheat • 1981 • Supply: Qs = 1,800 + 240P • Demand: QD = 3,550 - 266P • Equilibrium price and quantity was $3.46 and 2,630 million bushels Chapter 9

  49. Supporting the Price of Wheat • 1981 • Price support was set at $3.70 • QD + QG = QDT = 3,440 -266P + QG • QS = QD 1,800 + 240P = 3,550 - 266P + QG QG = 506P -1,750 QG = (506)(3.70) -175=122 million bushels Chapter 9

  50. AB consumer loss • ABC producer gain S By buying 122 million bushels the government increased the market-clearing price. Qg P0 = $3.70 C A B P0 = $3.46 D + Qg D 1,800 2,566 2,630 2,688 The Wheat Market in 1981 Price Quantity Chapter 9

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